Regulatory Horizons – Episode 5 – Alethea Nugent

ESG for Asset Managers – Draft Amendments to MiFID II, the AIFMD & UCITS

Scene Setting

In March 2018 the European Commission (EC) published an ambitious Action Plan on Financing Sustainable Growth, including 10 Action Points for financial services firms.  Action Point 7 is – Clarify institutional investors’ and asset managers’ duties. 

There are a number of different aspects to Action Point 7 if you are an asset manager, these are the new regulations and changes you need to pay attention to now, as the first deadline is March 2021:

  1. Sustainable Finance Disclosure Regulation (SFDR) – published 9th December 2019
  2. Joint Consultation Paper – ESG Disclosures – published 23rd April 2020
  3. Draft amendments to the Delegated Directives/Regulations of MiFID II, the AIFMD and UCITS – published 8th June 2020

The SFDR aims to achieve greater transparency in how firms (referred to as financial market participants) consider Sustainability Risks (definition below) in their investment decision making.  This is mainly achieved through disclosure on a ‘comply or explain’ basis.  The Joint Consultation Paper is the first of several Regulatory Technical Standards needed to flesh out the content, methodology and presentation of the SFDR disclosures.  The Draft amendments to the Delegated Directives/Regulations were needed to provide the basis for the SFDR and were only open for consultation until 6th July 2020.  They should be adopted by the EC in Q3/Q4 2020.

A quick note on Brexit here – as mentioned, the first set of disclosures is expected by March 2021 – after the transition period ends in December 2020.  So, we await the FCA’s decision on implementation of the SFDR.  They will want to promote equivalence, but as we’ve just seen with the new prudential regime for investment firms (FCA Discussion Paper 20/2 June 2020), the FCA may want to make some changes to suit the UK market.

This note focuses on the Draft amendments to MiFID II, the AIFMD and UCITS to help you broadly understand what the SFDR wants firms to do – this should make it easier to then dive into the technicalities of the disclosures of the SFDR itself.

Definitions

Before we start there are some key definitions from the SFDR to be aware of that are carried through into the Draft amendments:

Sustainability Risks – environmental, social or governance events which, if it occurred, could cause a material negative impact on the value of an investment.

Sustainability Preferences – a client or potential client’s choice of whether to incorporate sustainable investments into their investment strategy.

Sustainability Factors – environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery.

Draft amendments to the Delegated Directives and/or Regulations of MiFID II, the AIFMD and UCITS

The Draft amendments are designed to incorporate sustainability objectives into the existing conduct of business and organisational requirements of these three Directives.

What are the changes?  If you’re anything like me, you went straight to the Draft amendments to find this out for yourself – but found that ESMA hasn’t provided a blackline version, making the changes quite difficult to see.  So, I’ve done the hard work for you and provided a high-level overview, along with the Articles to make it easier.

Markets in Financial Instruments Directive II (MiFID II)

Article What are the changes?
21 – General Organisational Requirements
  • Firms must take Sustainability Risks into account throughout their governance and organisational framework, while taking into account their nature, scale and complexity
23 – Risk Management
  • Firms must implement and maintain risk management policies which take into account Sustainability Risks
33 – Conflicts of Interest
  • Firms must identify conflicts of interest which may damage the interests of clients – including their Sustainability Preferences
Article 52 – Information about Investment Advice
  • Firms must provide a description of their investment selection process to clients which includes risks, costs, complexity of the financial instruments involved and any Sustainability Factors
Article 54 – Assessment of Suitability and Suitability Reports
  • When providing investment advice or portfolio management services, firms must take into account the client’s risk tolerance and any Suitability Preferences
Article What are the changes?
9 – Product Governance for Manufacturers
  • Manufacturers must take Sustainability Preferences into account when identifying the target market for a financial instrument
  • Manufacturers must determine whether a financial instrument’s Sustainability Factors are consistent with the Target Market
  • When a Manufacturer conducts a regular review, it should consider whether the financial instrument remains consistent with the target market – including their Sustainability Preferences

 

10 – Product Governance for Distributors
  • Distributors need product governance arrangements which ensure the products and services offered or recommended are compatible with the target market, including any Sustainability Preferences
  • When reviewing the products and services offered or recommended, distributors should assess whether they are consistent with the target market, including their Sustainability Preferences

 

Alternative Investment Fund Managers Directive (AIFMD) – https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/11960-Integration-of-sustainability-risks-and-factors-related-to-alternative-investment-fund-managers- 

Article What are the changes?
18 – Due Diligence
  • AIFMs must:
    • Take Sustainability Risks into account; and
    • Consider principle adverse impacts on Sustainability Factorswhen selecting and monitoring investments in accordance withthe objectives, investment strategy and risk limits of the AIF
22 – Resources
  • AIFMs must employ enough personnel with the skills, knowledge and expertise necessary to effectively integrate Sustainability Risks
  • Taking into account the nature, scale and complexity of their activities and the nature and ranges of services undertaken
30 – Types of Conflicts of Interest
  • AIFMs must identify conflicts of interest that might damage the interests of the AIF as a result of integrating Sustainability Risks into its processes, systems and internal controls
40 – Risk Management Policy
  • The risk management policy must include procedures that enable the AIFM to assess the exposure of the AIF to Sustainability Risks
57 – General Requirements
  • AIFMs must take Sustainability Risks into account in its organisational and governance structure
60 – Control by the Governing Body and Senior Management
  • The Governing Body, Senior Management (and where relevant Supervisory Function) are responsible for the integration of Sustainability Risks into the following for each AIF:
    • General investment policy (including legal documents), investment strategies and risk limits;
    • Valuation policies and procedures;
    • Risk management policy, arrangements, processes and techniques for implementation, including the risk limit system;
    • Permanent and effective compliance function;
    • Monitoring of investment decisions consistent with approved investment strategies; and
    • Remuneration policy

UCITS 

Article What are the changes?
4 – General Requirements on Procedures and Organisation
  • Management Companies (ManCo’s) must take Sustainability Risks into account in its organisational and governance structure
5 – Resources
  • ManCo’s must employ enough personnel with the skills, knowledge and expertise necessary to effectively integrate Sustainability Risks
  • Taking into account the nature, scale and complexity of their activities and the nature and ranges of services undertaken
5a – Obligation for investment companies to integrate Sustainability Risks in the management of UCITS
  • Investment companies must integrate Sustainability Risks in the management of UCITS, taking into account the nature, scale and complexity of the business of the investment company
9 – Control by Senior Management and Supervisory Function
  • The ManCo must ensure its senior management are responsible for the integration of Sustainability Risks into the following for each managed UCITS:
    • General investment policy (including legal documents), investment strategies and risk limits;
    • Permanent and effective compliance function;
    • Monitoring of investment decisions consistent with approved investment strategies; and
    • Risk management policy, arrangements, processes and techniques for implementation, including the risk limit system
17 – Criteria for the Identification of Conflicts of Interest
  • ManCo’s must identify conflicts of interest that might damage the interests of a UCITS as a result of integrating Sustainability Risks into its processes, systems and internal controls
23 – Due Diligence Requirements
  • ManCo’s must:
    • Take Sustainability Risks into account; and
    • Consider principle adverse impacts on Sustainability Factors

when

    • Selecting and monitoring investments in accordance with the objectives, investment strategy and risk limits of a UCITS;
    • Implementing their risk management policy;
    • Formulating forecasts and performing analysis of an investment’s contribution towards the UCITS portfolio composition, liquidity, risk and reward profile; and
    • Using third parties to perform risk management activities
38 – Risk Management Policy
  • The risk management policy must include procedures that enable the ManCo to assess the exposure of the UCITS to Sustainability Risks

What next?

This is one of those times when compliance can’t and shouldn’t drive the changes required – instead a business led project which compliance advises is needed.

ESG is one of those areas that is integral to the role of portfolio managers and if you work in a mid to larger firm you may already have an ESG team or process focusing on these matters.  If so, before the EC (and soon the FCA) get any further, it’s worth asking if a project is being set up and:

  • If so, making sure you understand where they are on their roadmap and what the timelines are; or
  • If your firm doesn’t yet have a project, this is the time for your Executive Committee or Board to identify a business Sponsor and set one up.

If your firm doesn’t yet have a formalised approach to ESG, there are some strategic decisions to make before you can even begin to think of setting up a project to start working on the Draft amendments and SFDR disclosures.  So, find out if your firm is aware of the changes and has started thinking about its response.  If it hasn’t your Head of Compliance needs to go and talk to the Executive Committee or Board soon.

This is a complicated one (more so than you might think), it reminds me of the Markets in Financial Instruments Regulation (MiFIR) level of complexity in some areas, so if you have any questions let me know, I’d be happy to talk them through.  Look out for my next article on the disclosures required by the SFDR – this is the next piece in the puzzle, and just to warn you it’s got maths in it that I haven’t seen the likes of since my Economics degree!

Written for CLARC by Alethea Nugent, Independent Compliance Consultant https://www.linkedin.com/in/alethea-nugent-799ab821/

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